in May 2002. According to an SEC official, SEC staff are currently reviewing the comment letters and developing recommendations for future SEC action on this topic.45
In July 2002, Congress enacted Section 401(a) of the Sarbanes-Oxley Act, which required that by January 2003 SEC issue final rules providing that annual and quarterly financial reports filed with SEC disclose all material off-balance sheet transactions, arrangements, and obligations. On January 22, 2003, SEC adopted rules to implement that section. These rules
stipulate that financial reports that public companies are required to file with SEC after June 15, 2003 include an explanation of the company’s financial condition disclosing material off-balance sheet transactions, arrangements, obligations, and any relationships the issuer has with unconsolidated entities.46
In August 2002, pursuant to Section 302(a) of the Sarbanes-Oxley Act, the SEC adopted rules to require the certification of an issuer’s quarterly and annual reports by its principal executive and financial officers. SEC also adopted rules requiring issuers to maintain and regularly evaluate the effectiveness of disclosure controls and procedures. Among other things, the certifications state that the overall financial disclosure fairly presents, in all material respects, the company’s financial condition, results of operations and cash flows. A “fair representation” of an issuer’s financial condition and results of operations and cash flows encompasses the selection of appropriate accounting policies, proper application of
appropriate accounting policies, disclosure of financial information that is informative and reasonably reflects the underlying transactions and
events, and any additional disclosure necessary to provide investors with a materially accurate and complete picture of an issuer’s financial condition and results of operations and cash flows. Such certification forces the executive officers to not only certify whether the company’s financial statements are prepared in compliance with generally accepted
accounting principles, but also whether the financial statements and other financial information fairly present in all material respects the financial condition and results of operations and cash flows of the company.
45
Disclosure in Management’s Discussion and Analysis about the Application of Critical Accounting Policies, Release No. 33-8098 (May 10, 2002).
46
“Disclosure in Management’s Discussion and Analysis about Off-Balance Sheet Arrangements and Aggregate Contractual Obligations,” Release No. 33-8182 (January 27, 2003).
In addition, Section 402 of the Sarbanes-Oxley Act requires that SEC complete a study by January 2004 to determine not only the extent of off- balance sheet transactions and the use of SPEs but also the degree to which the economics of such transactions are transparently conveyed to investors. The act also requires that SEC report to the President, the Committee on Banking, Housing, and Urban Affairs of the Senate, and the Committee on Financial Services of the House of Representatives 6 months after the study is completed on the following:
• public companies’ off-balance sheet transactions and use of SPEs,
• the extent to which SPEs are used to facilitate off-balance sheet transactions,
• the extent to which current rules and accounting principles result in financial statements that are transparent with respect to SPEs and off- balance sheet transactions,
• the extent to which current accounting principles result in the
consolidation of issuer-sponsored SPEs when the issuer carries most of the SPEs risks and receives most of its rewards, and
• recommendations for improving the transparency of reporting off-balance sheet transactions in public companies’ financial statements.
In response to controversies related to Enron’s use of SPEs, the accounting guidance related to SPE financial reporting was clarified in January 2003 when the Financial Accounting Standards Board released Interpretation No. 46, Consolidation of Variable Interest Entities.47
In general, this new guidance requires that an SPE be consolidated with another entity if that entity is the primary beneficiary48
of the SPE—that is, if it absorbs the majority of the risks and rewards of the SPE’s operations. Specifically, an SPE would be consolidated with its primary beneficiary if the outside equity investment was not at least 10 percent of its total assets49
and is not greater than its expected losses, or if the outside equity holders in the SPE lack (1) the ability to make decisions about the SPE’s
47
This guidance refers to an SPE subject to consolidation as a variable interest entity.
48
For purposes of determining whether an entity is the primary beneficiary, an entity with a variable interest (ownership or some other financial interests) shall treat variable interests held by its related parties as its own interest.
49
Prior to this guidance, 3 percent was used as a criterion to determine whether to consolidate an SPE with another entity. This 3-percent test did not originate in a Financial Accounting Standards Board standard but rather was contained in a supplement to an EITF issue related to leasing transactions involving SPEs and subsequently appears to have become the de facto test for all SPEs.
activities (control), (2) the obligation to absorb expected losses of the SPE if they occur (risk), and (3) the right to receive residual returns of the SPE if they occur (reward). Many SPEs that were previously unconsolidated will be consolidated as a result of the interpretation, starting with their first fiscal year or interim period beginning after June 15, 2003.
According to some allegations, some research analysts at investment banks recommended Enron and Global Crossing securities to investors in order to get lucrative investment bank deals for their firms. Such analysts are better trained and positioned than the average retail investor to assess the value of a company’s securities. The value and credibility of their recommendations depend on their maintaining unquestioned
independence and objectivity in their research and resulting investment recommendations. The issues surrounding research analysts’ actions in recommending Enron raise a number of serious questions, primarily concerning the effectiveness of barriers between the research and investment banking functions of investment banks. In response to this concern, regulators have introduced new rules designed to reduce such conflicts of interest, and a number of other actions have been initiated.